Investing In An Uncertain Market With Options

Includes: SPY
by: Reel Ken

"It's not a market of stocks, it's a stock market"...Reelken

Those that read this quote carefully will notice that I deliberately reversed "ye ol' cliche". The premise of "ye ol' cliche" is that selective stock picking is the best way to navigate the stock market. This is promoted mostly by "talking head" pundits who, by inference, are the ones to lead us to the "promised land".

To me, it is self evident that picking the best stocks will outperform the overall market. It is equally self-evident that the odds of anyone, even the pros, consistently doing this is small. Evidentiary to this claim is the simple fact that the overwhelming amount of invested capital is NOT in the best performing stocks. The bell curve is the bell curve.

One must choose to either "get on board" with the "Big Boys" or do-it-yourself. If you've got a manager that is a consistent winner, stay with them. For me, I prefer DIY investing.

Unfortunately, most investors approach the market as if it was a Rubik's Cube. If they could only master how to manipulate the pieces, the secret will be revealed. In fact, investing is more akin to assembling a 2000 piece Jig-Saw puzzle whilst being deprived of ever seeing the whole picture.

It used to be that earnings misses/hits/exceeds meant something. The hedge funds, hi-frequency traders, prop-desks and their ilk have rendered this all mute. A stock can miss and go up, exceed and go down. Even if the direction is appropriate, the next week they "unwind". Tremendous sums of money are influencing the outcomes by treating stocks as "trading vehicles" not investments. It's enough to drive one crazy.

Let's look at my favorite stock, Apple (AAPL). In one year it has gone from $350 to $640 back down to $530 and currently rests around $600. Now, thinly traded penny stocks behaving like this, sure, but do you have any idea how much money it takes to move a stock with this high a market cap, this much? Only the most disciplined investor can survive this.

But it's not just AAPL. Add Caterpillar (CAT), JPMorgan (JPM), BoFA (BAC), Amazon (AMZN), Priceline (PCLN), etc. to the list. Five to ten percent swings are commonplace. Just about every stock is a "timing" play. Hit it right or hit it wrong. The "traders" have a ball with this high volatility but the investor would prefer more predictability. I fear those days won't return for some time.

Given my view, I have essentially abandoned individual stocks for just a few ETFs.

ETFs offer diversification and are less prone to wild swings. Unfortunately, even they lean more to "trading vehicles" than investments. As a result, I find the only safe-haven in the most liquid and largest ETFs, such as SPY, IWM, QQQ and a few others.

I take it even one step further by using options on ETFs. This enables me to swiftly and easily adjust my portfolio anywhere along the long/short/neutral line that I find appropriate. I particularly like calendar spreads, especially when low-volatility favors buying options.

The advantage of a calendar spread is that one can sell near term options (one leg of the spread) either In-The-Money (NYSEARCA:ITM), At-The-Money (ATM) or out-of the-Money (OTM) to reflect their own bias towards a bull, bear or neutral market direction. Each week (for selling weeklies) or month (if monthlies are sold) the investor simply adjusts to their then current view and continues to sell options ITM, ATM or OTM. The second leg, purchasing a far-dated option, provides protection if the investor misses their prediction about the market.

Lets' look at the SPDR S+P 500 ETF (SPY) as an example. SPY currently trades at $135.49. I want a far-dated expiry, to minimize time decay, and choose the June 2013 expiry. When I'm uncertain about the longer range direction I choose to purchase the ATM option, in this case the $135 strike call for a debit of $10.46. An ATM option has a DELTA of around 50%, this means it will move about 50% of what the underlying moves.

Now, choosing the near-dated short-sale option is a little more complicated. The first step is to make sure I amortize the cost of the far-dated option. Since there are 52 weeks to expiry the weekly cost averages 20 cents ($10.46/52). I want to generate at least this amount of extrinsic value each week.

If I was bullish on the market this week, I'd sell next weeks OTM call. The $138 strike sells for 19 cents (all extrinsic, as needed)and gives me $2.51 SPY upside (almost 2%). So, If SPY moves up to $138, I gain about $1.25 (50%) of the move via the far-dated option and also pocket the 19 cent premium.

If the market moves up big, say, $3.51 to $139, the far-dated makes about $1.75 and the short-sold weekly loses 81 cents ( $139 minus $138 strike plus 19 cent credit). So, the far-dated call provides a 94 cent net profit, even as the short-sold option loses money. The reader should do the math, but there is no "upside loss" unless SPY reaches $141, a move of nearly 4% in one weeks time.

If the market moves down, I gain the 19 cents but lose about 50% of the move. So break-even is a drop of 38 cents (2x19 cents). Not what I want, but I chose "bull".

Now, I could be a little less of a bull and sell the $137 strike for 42 cents, or be "neutral" and sell the $136 strike for 84 cents. This lowers my upside gain on a bigger move but provides more leeway on a smaller or slightly down move.

If I was a "bear" I simply sell ITM calls. Once again, I want to make sure I generate at least 19 cents extrinsic value. I could go as "deep ITM" as a strike of $131 and receive a credit of $4.80 which would have 31 cents extrinsic. If SPY moves down, the short-sold call makes 100% of the down move (to SPY=$131) but the far-dated loses 50%, so the profit is roughly 50% plus the 31 cent extrinsic.

If the market moves up, the far-dated call will gain 50%, so I will break even at about SPY=$136.10. Once again, if I was less of a "bear" I could sell strikes closer to the money, say the $134, for $2.14 and receive 65 cents extrinsic and provide a little more leeway.

Now, as each new week comes and goes I may turn from bull to bear or bear to bull or go neutral. My overall success will depend on how often I get this right. That is the advantage/curse of the DIY investor and what I choose. Sort of "live by the sword..."

Conclusion: It is my belief that the market works against individual stock ownership. If the skilled investor wants to compete with the "Big Boys", fine and good luck. When, and if, fundamentals are rewarded appropriately, I'll go back in. But for now, the broad based market is an easier pick and options allow me to refine this even further and not have a uni-directional portfolio.

When employing calendar spreads, the most profit is realized when the investor "nails" the direction and magnitude correctly. Even if the weekly strikes are "over-run", there can be modest gains as long as the underlying doesn't make an extreme move. Now, there will surely be occasional wild swings, but by choosing broad based ETFs instead of stocks or thinly traded ETFs, I reduce these occurrences.

Disclosure: I am long AAPL.

Additional disclosure: I buy and sell options on SPY, QQQ and IWM